The Fed recently issued a press release stating that it would increase its Secondary Market Corporate Credit Facilities to not only purchase corporate debt on the secondary markets, but also ETFs. Another important change to its original capabilities is that the SMCCF is now allowed to purchase corporate debt that has been downgraded to “junk status” after March 22nd (fallen angels) in addition to investment grade corporate bonds and ETFs with over 50% of its assets allocated to corporate debt.
Along with the iShares iBoxx USD investment Grade Corporate Bond ETF (LQD) the SMCCF will now be able to purchase ETFs with sub-investment grade bond constituents such as the iShares iBoxx High Yield Corporate Bond ETF (HYG) and Spider Bloomberg Barclays High Yield Bond ETF (JNK).
According to Goldman Sachs, the Federal Reserve will also have limits on the amount of corporate bond and ETF purchases to 10% of an issuers outstanding debt and 20% of an ETF’s AUM. Goldman produced a list of corporate bond ETFs eligible for Fed purchases which totals $197 billion of AUM, $152 billion in investment grade corporate bond ETFs and $45 billion of high yield corporate bond ETFs. Applying the 20% limit per ETF, the Federal Reserve will be able to purchase just under $40 billion in corporate bond ETFs.
Over the past month short sellers have been very active in corporate bond ETFs but were covering part of their existing investment grade ETF short positions and adding to their high yield ETF short positions. Over the last thirty days, shorts covered -$2.1 billion of investment grade ETF shorts and shorted +$1.2 billion of high yield ETF shorts. But over the last week, we saw short selling in both types of corporate bond ETFs.
From 3/16 to 4/3 investment grade ETF short sellers covered -$2.63 billion of their exposure but added $163 million of new shorts over the last week. On the other hand, high yield ETF short sellers continued short selling throughout the last month, shorting +$441 million worth of ETFs in the first three weeks and ramping up their short selling over the last week to +$762 million. With the Fed buying ETFs in the near future, we will probably see short covering in both the investment grade and high yield corporate bond ETFs as prices surge when individuals and institutions trade alongside the wave of the Fed’s $40 billion of potential buy orders.
There are two ways for the market to fulfill the Fed’s ETF buying demand. The Fed can buy ETFs in the general market, buying from existing long ETF holders which will not increase existing ETF AUMs or buying newly created ETF shares which will increase ETF AUMs. Both paths effect the underlying ETF constituents and stock loan markets differently.
If the Fed buys ETFs from the open market, there will be no effect on the underlying bonds that make up these ETFs as the bonds that were needed to create the original ETF continue to reside in the ETF custodian banks and no new bonds will be needed to be purchased and created to create new ETF inventory.
The added buy side demand would drive up ETF prices and probably cause a larger price to fair value spread for these ETFs. If the spread is large enough, this may create a temporary arbitrage opportunity where traders would short the “overpriced” ETF and buy the underlying corporate bond constituents and reverse the trade once the spread recedes. This would create increased short-term volatility in these bonds, whipsawing prices\yields through the duration of the arbitrage opportunity.
If the Fed decides to buy newly created ETFs, there will be a need to purchase the underlying ETF bond constituents by the ETF creators to deliver to the ETF custody bank in order to exchange for shares of ETFs. This will create new buying demand for these underlying corporate bonds, driving prices higher and yields lower. If the Fed’s objective is to shore up the price and drive down the yields of these investment grade and especially high yield and “fallen angel” bonds, then buying newly created corporate bond ETFs would be the preferred option.
On the stock loan side, if the Fed buys already issued ETFs there would be a decrease in lendable availability in these ETFs as the Fed would probably not be lending their assets to facilitate short selling. Buying ETFs from long ETF holders who were in lending programs will lead to higher stock borrow rates and tightness in the stock loan market.
If the Fed buys newly created ETFs there will be no effect in the stock loan market as existing long ETF holders\lenders will not be displaced and the overall lendable ETF inventory will not be affected.
Finally, if the Fed does buy $40 billion worth of corporate bond ETFs there will be some positive pricing effect to these ETF prices. On a year-to-date basis, corporate bond ETF short sellers have had a profitable 2020 with investment grade short-sellers up $335 million, +8.34%, in mark-to-market profits while high yield short sellers were up $595 million in mark-to-market profits, +5.34%.
While short sellers were profitable in both types of corporate bond ETFs over the longer term, this was not the case in the short term. High yield shorts were down -$285 million, -3.34%, in mark-to-market losses over the last month with -$926 million, -8.48%, of losses coming in just the last week as prices rallied on the Fed purchase news. The HYG ETF was down -$772 million over the last week on its own. On the investment grade ETF side, shorts were still up +$139 million, +5.32%, for the month, but were down over the last week as well. Losing -$139 million, -5.01% in mark-to-market losses.
Fed buying will certainly drive up corporate bond ETF prices, producing even more mark-to-market losses for existing short sellers. The buying will also increase stock borrowing cost in the ETFs as well. The two-pronged hit of losses coupled high financing costs will create a short squeeze that will force ETF shorts to cover their shorts in order to realize some of their year-to-date unrealized profits.
Depending on how the Fed executes its corporate bond ETF purchases there may or may not be a direct effect on the stock loan side of the market, but $40 billion on bid-side pressure will certainly move the market against these short positions. If the short position is used as a hedge to a long corporate bond portfolio, then the hedge just got more expensive to hold. If the short position is an Alpha play, then the net of financing expected Alpha just got smaller than what was expected a month ago.
Either way, keeping track of these corporate bond ETF AUM’s, short interest and stock borrowing rates will give investors\traders insight into the Fed’s corporate bond ETF trading activity. Using S3’s Blacklight SaaS platform and Black App will give investors\traders daily and timely insight into this opaque part of the market.
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Managing Director Predictive Analytics, S3 Partners, LLC
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